Two significant legal issues arise in short sales: liability for a deficiency and taxes.  A “deficiency” is the difference between the amount owed on the loan and the market value or sales price.  When a foreclosure is pursued on a borrower’s principal residence in Oregon under trust deed, no deficiency or personal liability can attach to the homeowner.  The first mortgage holder can get the house, but not a court judgment against the homeowner.  The second mortgage holder can still sue the homeowner, however, unless the first and second mortgages were given by the same lender to purchase the property (sometimes called a “80/20” purchase loan). 

A short sale won’t extinguish the debt UNLESS there is a writing (called a “release”) signed by the lender stating that they won’t hold the seller liable for a deficiency.  A condition in the purchase and sale agreement between the seller and the short sale buyer won’t do it – the lender isn’t a party to that agreement. 

Holders of second trust deeds in short sales don’t typically forgive the debt. They might accept a partial payment, say $2,000; and then sell the balance due on the loan to a collection agency.  A second mortgage holder might refuse to release their lien allow a short sale to close unless “greenmail” money is paid by the seller.  This is not a full release from deficiency.  It makes no financial sense for the seller to agree to pay this if there is not a full release, as the lender could still pursue a deficiency judgment.  The only way to extinguish this liability would be through a bankruptcy.

The Mortgage Debt Relief Act of 2007 may allow you to avoid having debt forgiveness included in your income.  When debt is forgiven through a short sale or foreclosure, it would usually be counted as taxable income to you, even though you don’t receive any money from the sale.  Mortgage debt used to buy, build, or substantially improve your principal residence may be excluded from your income in tax years 2007 through 2012.  Up to $2 Million can be excluded ($1 Million for Married filing separately).  Refinance debt to improve your home can be excluded, but not debt to pay off credit cards or make other purchases.  Debt for second homes, rentals, business property doesn’t qualify.  However, tax relief might apply if you are “insolvent” at the time of the tax forgiveness.  Insolvency is when total liabilities (prior to the cancellation of debt) exceed total assets.  You can be “insolvent” without filing for bankruptcy.  Debt forgiven as part of a loan modification can also be excluded. 

You should get a Form 1099-C, Cancellation of Debt, from your lender which shows the amount of debt forgiven and the fair market value of the property sold or foreclosed.  To claim the exclusion, you need to fill out and attach an IRS Form 982 to your return for the year in which the debt was forgiven.  You can only exclude cancelled debt up to the amount of your insolvency (liabilities minus assets).  A good resource is IRS Publication 4681: Canceled Debts, Foreclosures, Repossessions and Abandonments. Publication 4681.  Similar tax issues would arise if, for example, you are able to pay off credit card debt for an amount less than the balance due.

In addition, a foreclosure is treated as a sale for the purpose of calculating any gain or loss.  Assuming that you are not personally liable for the debt because it is your personal residence, the amount “realized” through the foreclosure is the amount of debt prior to the foreclosure.  The gain or loss is determined by subtracting your adjusted basis in the property from the amount of the debt.  The lender who acquires the property through foreclosure will send you a Form 1099-A.  Losses related to a home are not deductible.  Gains up to $500,000 for married couples and up to $250,000 for single individuals are not taxable. 

Short sales may involve legal traps for the unwary because of the potential liability for a deficiency judgment.  Tax issues may also be quite complex.  If you are considering a short sale, the best protection is get competent advice before entering the transaction.

Suits to “quiet title” to real property have had a statutory basis in Oregon since 1862. Suits to quiet title are sometimes referred to as suits to remove a cloud on title. Although Oregon is famous for overcast skies, the cloud referred to here is any doubt or uncertainty as to the validity of the plaintiff’s title. Cases describe a cloud on title as a lien, claim, or other encumbrance that is apparently valid on its face, but that can be established to be without foundation or merit.

When you take out a mortgage loan to buy a home, you sign a promissory note held by the lender.  The promissory note gives the holder the right to collect payments. A deed of trust is recorded at the county recorder’s office to secure payment of the loan, and gives the lender the right to foreclose on the property if you default on the loan.  (Oregon is a “title theory” state, meaning that the trustee appointed by the lender holds legal title to your property, subject to the conditions of the trust deed.)

As discussed in my last post, foreclosures involving MERS (the Mortgage Electronic Registry System) are suspect, and title companies in Oregon are now excluding any failures to record assignments from title insurance coverage for such foreclosures.   MERS cannot be the “beneficiary” or holder of the promissory note because it has no financial interest in any mortgage loans.

In Utah, also a title theory state, there have been several recent cases granting homeowners title free of liens in quiet title cases. If the lender listed on your deed of trust subsequently sold the loan (or if they no longer exist due to bankruptcy or merger), they may not bother to contest a quiet title action.  The title company listed as trustee might also disavow any interest in the loan or the property.  In the Utah cases, the homeowners won default judgments because neither the original lender nor the title company listed as trustee appeared in the case. The attorneys argued that MERS did not have to be served because MERS is not the beneficiary of the trust deed.  That might work in Oregon, given recent federal court decisions to that effect.

The award of a title free of liens means that whoever owns the promissory note no longer has the right to foreclose.  That means the promissory note, perhaps now owned by investors, may be worth far less than they paid for it because it is no longer backed by an asset. While a quiet title judgment may prevent the note owners from foreclosing, it does not preclude them from suing on the note.   

A promissory note is a “negotiable instrument.”  Like a check, you have to be in physical possession of the document to enforce it.  For example, you couldn’t cash a photocopy of a check instead of the actual check. In many cases, there may be no one in a position to try to collect because the actual notes are either lost or destroyed. 

Individuals in several circumstances might consider quiet title actions.  First, those who bought MERS foreclosed properties may need to clear title to be able to sell.  Second, those with MERS on their existing deed of trust may want to test the validity of the mortgage.  Third, those who have lost their homes to foreclosures in which MERS was involved may be able to argue that their interest in the property is superior due to a defective foreclosure process in which assignments were not properly recorded.

For these reasons, quiet title actions might not be so quiet in the near future.  Instead, they might sound like the approach of a not too far off tsunami.

Central to these recent decisions is ORS 86.735, which provides that a nonjudicial foreclosure by advertisement and sale is permitted in Oregon only if “any assignments of the trust deed by the trustee or the beneficiary and any appointment of a successor trustee are recorded in the mortgage records . . ..”  A trust deed is a three party arrangement between the lender, borrower, and the trustee, who releases the mortgage lien when the loan is paid or conveys title to the lender after foreclosure if the loan is not paid.  Without recording all assignments, a foreclosure cannot go forward.

In the Rinegard-Guirma case, Judge King found that MERS was not really the “beneficiary” (even though labeled as such in the trust deed) because the trust deed was for the benefit of the lender to secure payments under the note, not MERS.  Judge King looked to cases from Oregon and elsewhere which indicate that assignments of the trust deed, without the note, are not effective.  MERS has no authority to transfer the note.  Like Siamese twins joined at birth, the note and trust deed cannot be split – no assignment of trust deed alone is effective.

In Burgett, Judge Hogan stated that unrecorded assignments of trust deeds are permissible, but not if foreclosure by sale is sought.  All prior unrecorded assignments must be filed in a nonjudicial foreclosure by sale.  In McCoy, Bankruptcy Judge Alley made the same findings, while noting that ORS 86.735 does not restrict judicial foreclosures.  There were four separate unrecorded assignments in McCoy as part of a securitized loan pool put together by now defunct Lehman Brothers.

In the Barnett and Eckerson cases, Judge Brown reviewed the prior decisions by Judge Hogan and Judge King and found that foreclosures involving MERS could not proceed.  Homeowners 5, MERS zero.

In Barnett, Judge Brown also found that the lender, BAC, may have breached a loan modification agreement with the borrower.  In a classic case of “dual track” foreclosure, BAC was negotiating a loan modification with the homeowner and at the same time it was pursuing foreclosure. Apparently the left and right hands did not communicate.  Lenders’ computer systems, once programmed for foreclosure, are extremely difficult to override.

All of these decisions — involving restraining orders, injunctions, and motions to dismiss or for summary judgment — are preliminary in nature and do not necessarily mean the lenders will eventually lose.  However, in a few short months Oregon has developed an impressive set of precedents indicating foreclosures involving MERS are suspect.  The lenders may have a very difficult time getting the assignments they need in these cases because several links in the chain of assignments (Lehman, La Salle Bank, Countrywide) are either bankrupt or no longer exist.

Hundreds of foreclosures already in process in Oregon have been rescinded in the past few weeks, because title companies are now excluding the failure to record assignments from title insurance coverage for nonjudicial foreclosures.  Are the lenders likely to regroup and file them as judicial foreclosures?  Probably not, since the filing fees in State Court are hefty, and homeowners and lien holders have a six month period of redemption after any judgment.

So where does that leave us?  Without any legislative solutions, either state or federal, we’re exactly in the same place we’ve been since the mortgage crisis began three years ago – in limbo.

I was talking to a Medford lawyer last week after finally completing the settlement of a hard fought foreclosure defense case which resulted in a loan modification.  “Maybe I need to hire you for my own mortgage,” he said.  “What do you mean?”  He proceeded to tell me about the 30 year fixed mortgage he applied for, but when it came time for closing, the terms were changed to an adjustable rate with a balloon payment after ten years.  This is what is called in Consumer Law a “bait and switch” tactic by the mortgage broker.  A “simultaneous closing” was scheduled by the broker, meaning that if the Medford lawyer backed out of the deal, the seller’s closing on the new house they were buying would also fall through.  Because others would be impacted, he decided to go through with it, even though the loan terms were not as promised.  Now, along with many of us, the Medford lawyer is stuck with negative equity and is anxious about whether the market will recover before the loan is due in five years.

Since he had shared his “big mistake,” I decided to share my own “D’oh!” moment (quote from Homer Simpson).  I was looking to downsize a year ago and found a condo I made an offer on.  I wanted to impress the seller, a local developer, how serious I was, so I put in a $5,000 earnest money deposit.  I used a reputable real estate agent.  After the offer was accepted, the agent started talking about the developer working with the bank to release liens so the condo could be sold, because the property was in foreclosure.  “What?!”  (“D’oh!”)  Imagine how stupid I felt, as an Ashland lawyer and a real estate license holder myself.  I hadn’t asked enough questions about the seller’s financial integrity and the status of his title to the property.  When the preliminary title report came in, I realized the deal was never going to close because there were too many liens against the property.  I demanded my earnest money back.  The developer, thankfully, agreed to release my five grand.  (Once the money is in escrow, the title company can’t release the funds unless both parties agree).  The last time I saw the developer was at his Creditor’s Meeting in bankruptcy court.

Here are the morals to these stories:  1) Don’t be pressured to sign something you didn’t agree to.  The incentive of the professionals involved (mortgage broker, realtor, escrow officer) is to close the deal: that’s how they get paid.  Don’t sign if something’s not right.  2)  Go skinny on your earnest money ($500 will do).  You might not get it back if you have to walk away from the deal.  3)  It is likely that nearly every mortgage and foreclosure started after 2004 has problems.  You won’t know unless you get a professional evaluation of your circumstances.  4)  “Everybody makes mistakes.”  When you do, it’s better to admit it, get over your guilt, and seek professional help in fixing the problem.  If the mistake involves real estate, mortgages or personal finances, give us a call.  We’re here to help.